Professional Documents
Culture Documents
The following summary is based on two chapters in the Handbook of Industrial Organization: 1. 2. Chapter 2 on The Theory of the Firm Chapter 3 on Transaction Cost Economics
As the chapters were published in 1989, a great deal of recent research is not included However, key issues and open questions remain substantially the same
Main Issues
Behavior and organization within the firm is poorly understood relative to interactions between firms in markets; the lack of data probably accounts for much of this gap Even though applied research in this area is difficult, it is important to be aware of the main issues because they have implications for work in other areas For example, firm behavior is the result of a complex joint decision process within a network of agency relationships employees are not owners If agency problems are sufficiently severe, the firms in question may not maximize their value
1. Limits of Integration
What determines the scale and scope of a firm? Perhaps surprisingly, we do not have very good answers to this question It is difficult to specify measurable tradeoffs between the benefits and costs of integration Firms form, so some integration is optimal, but all transactions are not organized in a single firm, so there must be costs to increasing size Williamson (1975, 1985) poses the problem as one of selective intervention: why not combine all firms into one and intervene in their operations only when doing so is profitable?
Firm Size
Microeconomics texts refer to long run average costs curves that eventually slope up What are the sources of diminishing returns to scale? Lucas (1978) focuses on scarce managerial inputs Geanakopolos and Milgrom (1985) refer to the benefits of coordination balanced against the costs of communication and information acquisition Lucas (1967) focuses on adjustment costs that limit firm growth; Jovanovic (1982) emphasizes imperfect knowledge about ability that limits growth these perspectives do not impose caps on size per se
Incomplete Contracts
The technological models do not really address the selective intervention problem A more productive approach considers problems with contracting that prevent selective intervention Williamson (1975, 1985) emphasizes that contracts are incomplete In reality, it is essentially impossible to use a contract to describe appropriate behavior in every contingency for every party This has implications for organization: when irreversible investments are required, contractual incompleteness can lead to hold up, which favors integration
Influence Costs
Milgrom (1988) emphasizes that integration results in costly influence activities, which are essentially rent seeking activities undertaken by employees within the firm Non-market organizations are susceptible to influence costs because they have an authority structure that can affect resource allocation and because there are quasi rents associated with jobs within the hierarchy Bureaucratic inflexibility may be a rational response of firms to limit the extent of influence activities
2. Capital Structure
Modigliani and Miller (1958, 1963) established that capital structure is irrelevant: the value of a firm in a frictionless and tax-free capital market is independent of the mix of equity and debt and changes in dividend policy The reasoning is straightforward: If the value could be changed by altering the financial mix, there would be a pure arbitrage opportunity An entrepreneur could purchase the firm, repackage the same return stream to capitalize on the higher value and yet assure the same risk by arranging privately an identically leveraged position
Early extensions
Intuitively, MM cannot be the final word on this subject Real world firms invest considerable effort in determining their financial structure Social bankruptcy costs and non-neutral tax treatments were early considerations that modified MM Equity reduces expected bankruptcy costs Taxes favor debt financing More recent explanations consider the incentive effects of capital structure, signaling, and the effects of changes in control rights
Incentives
Jensen and Meckling (1976) originated the incentive argument Firms are run by self-interested agents, not pure profit maximizers The separation of ownership (which implies claims on the profits) and control (management) gives rise to agency costs There are agency costs with both equity and debt
The Tradeoff
The optimal capital structure minimizes total agency costs: the debt-equity ratio should be set to equalize the marginal agency costs Measurement problems are enormous One qualitative prediction is that firms with substantial shirking problems will have little outside equity, while firms that can substantially alter the riskiness of the return will have little debt
Signaling
Some models suggest that the debt-equity ratio signals information about the return distribution Myers and Majluf (1984) argue that adverse selection poses problems for raising outside equity Suppose the market is less informed about the value of the firms future cash flows than the manager of the firm and that there is no new investment to undertake Then no new equity from new shareholders can be raised if the manager is acting in the interest of the old shareholders
Signaling
The manager will be willing to issue new shares only if they are overvalued (for example, if the shares are priced at 120 and the manager knows they are only worth 100) Realizing this, no one will buy the new shares at the asking price Realizing this, the manager will avoid issuing new shares unless debt is not a desirable alternative (for example, if there is so much debt that more might lead to financial distress)
Signaling
Suppose capital is needed for an investment By the same reasoning, debt financing is generally preferred to equity financing If equity financing must be used then the stock price will always decline in response to a new issue (this result has empirical support) because the managers private information that the current shares are overvalued is revealed One way to see this is to note that if the share price were to increase with a new issue then it would always pay to raise equity irrespective of project value!
Control
The traditional explanations for capital structure ignore the fact that equity has voting rights; equity is not just a right to a residual return stream Similarly, debt contracts typically include some contingent control rights The distribution of control rights is important for incentive provision given that contracts are incomplete A complete theory would explain why equity holders have voting rights and why debt contracts are linked to bankruptcy mechanisms
Internal Discipline
Executive compensation plans often have incentive provisions: bonuses, stock, stock options, and other contingent compensation Extensive theoretical and empirical work on executive compensation has been done Further, directors are supposed to monitor managers In practice, directors may lack adequate incentives; many have close ties to the managers Following the publication of the handbook, there has been additional work on boards of directors and their roles in incentive provision and monitoring, but there is more work to be done
Behavioral Assumptions
Friedman (1953) reflects the view of most economists: the realism of assumptions is not important; the usefulness of a theory depends on its implications Williamson argues that assumptions are important; behavioral assumptions determine the set of feasible contracts, for example Williamson describes contracting man as opposed to rational man Contracting man is subject to bounded rationality and opportunism Efforts to mislead, disguise, confuse are possible: these are difficult to incorporate into rational actor models
Incomplete Contracts
Bounded rationality and opportunism imply: All feasible contracts are incomplete
Given this, structures that facilitate gapfilling, dispute settlement, adaptation, etc., are part of the problem of economic organization 2. Contracts are not guarantees Institutions that mitigate opportunism are important
Transactions
Generating testable implications from transaction cost economics requires that we describe features of transactions that affect transaction costs According to Williamson, transactions differ along three dimensions: The frequency with which they occur The degree and type of uncertainty to which they are subject Asset specificity Asset specificity is the most critical attribute
1. 2. 3.
Asset Specificity
Asset specificity refers to the degree to which an asset can be redeployed to alternative uses and by alternative users without sacrificing its productive value Given that contracts are incomplete and contractual man is opportunistic, investments in relationship specific assets are discouraged A simple dynamic model can illustrate the problem: initially parties agree on an ex post division of the surplus, then one party makes such an investment, then the other party may attempt to bargain for more favorable terms (incompleteness allows that this is possible) Looking ahead, the investing party under-invests
Asset Specificity
Asset specificity can take many forms Firm-specific human capital is one example Untenured faculty members tend to under-invest in location-specific activities (serving on university committees, etc.) and emphasize investments that the market values (publications in refereed journals) A faculty member who invests solely in location-specific activities is vulnerable to being exploited by his/her employer
Capital Structure
Transaction cost economics emphasizes that the asset characteristics of investment projects matter, and that the governance structure properties of debt and equity are key attributes The attributes of projects and the governance structure differences between debt and equity should be aligned in a discriminating way When physical asset specificity is moderate, projects are easy to finance with debt When asset specificity rises, the claims of debt holders afford only limited protection because the asset is not re-deployable The benefits of closer oversight also grow when asset specificity rises These effects make equity finance (which is more intrusive through the board of directors and through large shareholders) more beneficial
Data Problems
When pursuing transaction-cost arguments, it is quite easy to tell loose stories that seem reasonable Recent research has emphasized that it is critical to dig deep into the data to formulate and evaluate transaction costs arguments For example, Kenney and Klein (1983) attribute the practice of block booking of films to measurement problems: no one could forecast success, so distributors would make all or nothing arrangements with exhibitors Recently, Hanssen questions this argument using evidence from real block booking contracts: exhibitors could exclude some films from the package
Data Problems
Klein, Crawford, and Alchian (1978) use GM-Fisher Body as an example of how relationship specific investments can lead to holdup and integration Recently, Coase questioned their findings based on a more in-depth investigation of the relationship between GM and Fisher Body Both block booking and GM Fisher Body have been the subject of recent debates in the literature It is important to get the institutional details right before theorizing about them